The basics of permanent life insurance

If you're shopping around for life insurance, there are a few questions to ask yourself: How much do I need? How long do I need it? And what type of policy should I buy?

When you've calculated your short- and long-term obligations (see how much life insurance do I need?), it's time to decide what type of policy is right for you: term life or permanent life insurance.

Term life insurance provides coverage for a specified period of time, such as 10, 15 or 20 years; premiums go up over time unless you buy a "level term" policy, which guarantees that premiums stay the same. It's possible that you could outlive the term of your policy, in which case your policy expires and you'd have to shop for another policy if you wish to still have coverage.

With a permanent life insurance policy, you don't have to worry about possibly outliving your policy term because your contract gives you coverage for your entire life, as long as the premiums are paid. With a permanent life policy, unlike term life, you also build up "cash value" in the policy that you can tap in the future.

Permanent life insurance charges and fees

Unlike term life insurance, permanent life insurance carries fees that add up:

• Premium loads/sales charges: These cover the insurance company's sales expenses and state and local taxes. They are deducted from your premium payment before it is applied to the policy.

• Administration fees: Pay the costs of maintaining the policy, including accounting and record keeping. Administration fees usually are deducted from your policy value once a month.

• Mortality and expense-risk charges: When your premium is calculated, the insurer bases your life expectancy on your current age, gender and health conditions. This charge compensates the insurance company in the case you don't live to the assumed age. It is charged once a month.

• Cost of insurance: The cost of having insurance protection. It is based on your age, gender, health and death benefit amount. It is charged once a month.

• Surrender charges: Deducted from your cash value if you surrender your policy during your surrender charge period. Be sure to check the length of your surrender charge period when evaluating a policy to buy.

• Monthly per thousand charge: This is a monthly charge based on your age, gender and underwriting classification.

• Fund management fees: These compensate the fund managers for their work. Fund management fees are usually deducted from the price paid for the shares of underlying fund options, and not directly from your cash value.

Source: Nationwide Life Insurance Co.

Premiums are significantly higher for permanent than term life due to charges and fees (see sidebar) that you don't pay with term life.

Cash value is a crucial selling point for whole life insurance: It's an account within your policy that builds up over time, tax-deferred, fueled by a portion of your premiums and interest paid by the insurance company. In fact, the permanent life contract is designed for you to take advantage of that money in the future. When you die, your beneficiaries receive the death benefit, not the cash value, with the exception of some universal life policies.

Permanent life policies build up cash value slowly at first but then pick up the pace after several years, when your earnings start to grow faster than your "mortality" cost (the cost of insuring you). Your life insurance agent should be able to show you a few types of policy illustrations.

State Farm Insurance points out that permanent life can be an attractive option for any of these reasons:

Others are relying on you for long-term financial support.

You're worried about outliving a term life policy and being unable to buy further insurance due to age or deteriorating health.

You want to build up cash value in addition to protecting your beneficiaries.

Berlin says whole life's advantages are that you don't have to worry about outliving your policy (as is possible with term life) and there is the "forced savings" component of the cash value account, which grows tax-deferred. Once your cash value is built up, you can access it for anything — retirement, your child's college tuition or the vacation you've always wanted. Whole life policies might be eligible to earn dividends (depending on the company and not guaranteed), which can be used in a variety of ways, such as providing paid-up additional life insurance, which increases both the life insurance benefit and cash value.

"Buying term is like renting your insurance," says Berlin. "You don't build up any residual value. Whole life is like owning a home — you build up equity."

Berlin cautions against buying term life insurance just because it's low cost life insurance.

"When you're 35 you think that 20 years is a long time, but life doesn't always work out like you think," he says. "People who buy permanent insurance understand the value of what they're providing to their family." For more on how cash value works and what you can do with it, see cash value in life insurance: What's it worth to you?

If you decide that a permanent life policy is right for you but feel you're currently unable to afford the premiums for the face value you desire, Berlin recommends buying as much whole life as you can afford and filling in the rest of your face amount with term life. Later, you can convert your term life policy to whole life.

For the wealthy with large estates, putting a whole life policy into a trust is a way to pay estate taxes when they die.

A smorgasbord of choices

Tips for shoppers of permanent life insurance

Find out the financial strength of the life insurer. Berlin explains the importance this way: "If someone owes you $250,000, who do you want to owe it to you?"

Have a good relationship with your agent — he'll need to locate policies that fit your financial situation.

Ask if there are protection features on the policy, such as a disability protection rider, because in the short term you are more likely to become disabled than to die.

Ask about the flexibility of the policy, such as your access to future cash value. Some whole life policies do not build up as much cash value as others.

Source: New York Life Insurance Co.

If the features of permanent life insurance fit the bill for you, there are multiple varieties depending on your needs and your tolerance for financial risk.

Ordinary whole life insurance: Premiums are level as long as you live and your policy builds cash value. The initial annual cost will be much higher than the same amount of term life insurance, but as you get older that gap closes.

Limited payment whole life insurance: This policy lets you pay premiums for only a specific period, such as 20 years or until age 65, but insures you for your whole life. Thus, premium payments will be higher than if payments were spread out through your lifetime.

Single premium whole life insurance: This policy is paid up after one large initial payment.

Modified premium whole life insurance: This policy has a moderate cash value component and provides a lower premium during the early life of the policy. It has the ability to accrue cash value that can be accessed by the policyholder, tax-free, for anything from funding a child's education to supplementing retirement income to purchasing a new home.

Universal life (UL) insurance: This policy lets you vary your premium payments and adjust your death benefit as beneficiaries' needs change. You have to be aware of how much is in your account and whether you need to make payments in order to keep the policy in force.

There are also UL policies that can provide level premiums. These policies may offer lower premiums in exchange for a slow accumulation of cash value, if any.

Variable universal life (VUL) insurance: Here your cash value and death benefit are tied to a particular investment account. Your cash value and death benefit increase if the underlying investments do well, or they may shrink considerably under poor investment performance. Read the prospectus for VUL carefully and never buy a policy that you don't understand. There may be an extra premium required to guarantee a minimum death benefit amount.

Survivorship life insurance: Also called second-to-die life insurance: This type of whole life policy insures two lives (typically a husband and wife) and pays out upon the death of the second individual. This is good for people who need to provide for beneficiaries only after both have passed away. It is also less expensive than insuring two lives under separate policies.

Participating or non-participating whole life insurance: Any type of permanent life policy listed above could be "participating" or "non-participating." You have a participating policy if your life insurance company pays dividends to policyholders when it has a good financial year. Dividends are not guaranteed and they will vary year to year when they are paid, but if you have a participating policy you can take your dividends as cash, use them to pay your premiums or use them to purchase additional insurance to increase your policy's face value.

Dividends are not taxable as long as they don't exceed the premiums you've paid in.

The life insurance illustration

Tapping life insurance cash value

Your policy's cash value account gives you some financial options once it has built up. You can withdraw your cash value and use it to pay for medical expenses or a child's education — or whatever you like. Or you could take out a loan using your cash value as collateral. If you die before paying back the loan, the amount (with interest) will be deducted from the death benefit paid to your beneficiaries.

Remember, the cash value grows tax-deferred.

In addition, federal and state bankruptcy laws exempt cash value (amounts vary by state), protecting it from creditors.

But also consider the implications of not tapping your cash value: With ordinary whole life policies, your beneficiaries do not receive the cash value when you die; they receive only the death benefit.

If you don't like this idea, there are some universal life policies that offer the death benefit plus cash value or the death benefit plus return of premium upon your death.

Source: New York State Insurance Department

If you're considering a policy in which premiums and death benefits fluctuate depending on investments or interest rates, you should receive a life insurance illustration from your agent. This is a picture of what could happen with your policy. Or again, maybe not.

The illustration should show you what the insurance company will guarantee (such as any guaranteed interest rates or death benefits) and what will be left open to market conditions. You'll be asked to sign a form stating you understand that some parts of the illustration are not guaranteed.

Being paid up

One happy stage of whole life insurance is when the policy's cash value is sufficient to cover your future premiums and you no longer need to make premium payments out-of-pocket. This is called a Premium Offset Proposal, or "POP" arrangement. "POP" means that your cash value is now large enough that it can be used by the insurer to pay your premiums for the rest of your life. You can still withdraw your cash value, but you'll have to resume premium payments to keep the policy in force or settle for a reduced benefit that the remaining cash value can support.

You could also choose a "limited pay" policy, for which your premiums are calculated for a set number of years or a certain age, like 65.

For example, New York Life offers "New York Life Custom Whole Life," a life insurance policy that lets you choose your own guaranteed paid-up date. (You must pay premiums for at least five years and cannot pay premiums past age 75 for this policy.) So, say you want to retire in 12 years and you want your policy to be guaranteed paid-up at that time. New York Life will calculate the premium necessary to have your policy fully paid-up in 12 years so that you won't have to worry about paying life insurance premiums during your retirement. If your need for the full life insurance benefit is reduced during your retirement, you can also begin withdrawing or borrowing from your cash value to supplement your retirement income.

Planning for all situations

Watch out for these sales tactics

The hard sell: An unscrupulous insurance agent may push whole life insurance when term insurance is sufficient for your needs; the whole life insurance sale provides him a larger commission.

Churning: If your agent suggests your current policy needs to be replaced, be wary. "Churning" is when an agent convinces you to surrender an old policy and buy a new one because he makes a new commission off you.

You thought you were paid up: Has your agent informed you that you must continue premium payments when you thought your policy was paid-up? You may have signed papers allowing your cash value to be used to buy another policy.

Source: National Association of Insurance Commissioners

Life insurance companies offer a number of riders that can be tacked on to permanent life policies. (All riders may not be offered by all companies, and many insurers offer other specialized riders not listed here, so check with your agent.)

Accidental death benefit rider: Pays an additional benefit if you die in an accident.

Disability income rider:Provides regular income from the insurance company if you become totally and permanently disabled.

Level term rider: Adds a fixed amount of term insurance to the whole life policy for a specified period.

Living benefits rider, also known as accelerated death benefit: Pays a portion of your death benefit during your lifetime if you are diagnosed with a terminal illness and have a specified life expectancy (such as 12 months). You can add this rider after buying the policy.

Long term care (LTC) rider: Pays for LTC expenses if you meet certain criteria.

Policy purchase option: Gives you the contractual right to purchase additional insurance without evidence of insurability. For example, you may need additional life insurance after the birth of a child.

Waiver of premium rider: Waives premiums if you become disabled or unemployed. (Terms vary by insurer.)

Term vs. perm: A comparison service

You've probably heard the advice "buy term and invest the difference." And to make that work you must have the financial discipline to actually invest that difference every year.

The Consumer Federation of America (CFA) offers a Rate of Return (ROR) service that provides you with a report comparing the estimated "real" investment returns on a cash value policy versus a term policy with the premium difference invested in a savings vehicle. The service is manned by James Hunt of the CFA, a life insurance actuary and a former insurance commissioner of Vermont.

Maximizing your cash value policy

Hunt says that because of the high fees associated with whole life, you want to look for ways to maximize your premium dollar within the policy. He suggests these strategies:

Decline all riders (except term riders on your own life and waiver of premium disability riders) because they'll eat into your cash value potential.

When you look at the policy illustration, make sure your first year's cash surrender value is a significant portion of your first year's premium outlay. (A good number would be 50 percent or higher.)

Consider buying direct rather than through a fully commissioned agent. Examples of direct sellers are Ameritas and TIAA-CREF. Returns on these "low-load" policies are generally higher than returns on comparable policies purchased through agents. Working with a direct seller will force the agent to arrange policy terms to reduce sales cost.

If you are looking at cash value life insurance to possibly supplement retirement income, Hunt advises that you may be better off buying term life and maximizing other tax-advantaged retirement plans first, such as your 401(k), 403(b), IRA or Roth IRA.

Wanting out of your life insurance policy

Perhaps you committed to a permanent life policy many years ago and no longer want or need it. If you simply stop paying the premiums, this will "lapse" your policy and you'll have to chalk it up to an expensive mistake. If you have held the policy long enough to build up cash value, your insurance company will start using the cash value to cover premiums until the cash value runs out.

Instead of lapsing your policy, inform your insurance company that you want to surrender the policy. You'll then receive the current cash surrender value, minus any loans against cash value you took out and unpaid premiums. You may also be hit with a surrender charge for getting out of a UL or VUL policy. Surrender charges can amount to 100 percent (or more) of the first year's premium and usually start to grade off over 10 to 15 years, according to Hunt. With some policies it may take 20 years before surrender charges disappear.

Or, if you have enough cash value, you can ask the insurer to consider the policy "paid up" at a lower death benefit.

Lapse and surrender rates for life insurance show that indeed there are many folks who end up with buyers' regret. Statistics from LIMRA International, a financial services industry research group, show that by policy year five, 69 percent of whole life policies are still in force; that drops to 50 percent in year 13 and 39.6 percent in year 20.

No matter your reasons for considering permanent life insurance, rule No. 1 is to never buy a policy you don't understand.